Present Value vs. Net Present Value: An Overview
Present value (PV) is the current value of a future sum of money or stream of cash flow given a specified rate of return. Meanwhile, net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
Present value tells you what you'd need in today's dollars to earn a specific amount in the future. Net present value is used to determine how profitable a project or investment may be. Both can be important to an individual's or company's decision-making concerning investments or capital budgeting.
While PVand NPVboth use a form of discounted cash flows to estimate the current value of future income, these calculations differ in an important way. The NPV formula also accounts for the initial capital outlay required to fund a project, making it a net figure. That makes it a more comprehensive indicator of potential profitability.
Since the value of revenue earned today is higher than that of revenue earned down the road, businesses discount future income by the investment's expected rate of return. This rate, called the hurdle rate, is the minimum rate of return a project must generate for the business to consider investing in it.
Key Takeaways
- Present value is the current value of a future sum of money that's discounted by a rate of return.
- It tells you the amount you'd need to invest today in order to earn a specific amount in the future.
- Net present value is the difference between the present value of cash inflows and cash outflows over a period of time.
- Both present value and net present value use discounted cash flows to estimate the current value of income.
- However, net present value also accounts for the initial outlay required to fund a project.
Present Value
The PV calculation takes a future amount of cash and discounts it back to the present day. The formula for this is:
Present Value = FV/(1 + r)n
where FV is the future value, r is the required rate of return, and n is the number of time periods.
Net Present Value
The NPV calculation takes the current value of future cash inflows and subtracts from it the current value of cash outflows. The formula for this is:
Net Present Value = cashflow/(1+i)t − initialinvestment
Where "i" is the requiredrateof return and "t" is the numberoftimeperiods.
Key Differences
| Present Value | Net Present Value | |
|---|---|---|
| Defined | Is the current value of a future sum of money discounted by a specified rate of return | Is the difference between the present value of cash inflows and the present value of cash outflows over time |
| Focus | Only accounts for cash inflows | Accounts for cash inflows and cash outflows that fund a project |
| Used By | Individuals and companies | Used mainly by companies |
| Importance | Helps investors understand whether an investment or expenditure is sensible | Helps companies determine the potential profitability of projects; essential for capital budgeting |
Examples
Present Value
Say that you can either receive $3,200 today and invest it at a rate of 4% or take a lump sum of $3,500 in a year. Calculating the PV of $3,500 can help you make a choice.
Present value = FV/(1 + r)n
Present value = $3,500/(1 + .04)1
Present value = $3,365.38
That means you'd need to invest $3,365.38 today at 4% to get $3,500 a year later. The $3,200 today will result in a smaller return. Based on that, you may feel that the lump sum in a year looks more attractive.
Net Present Value
Say that a company is considering investing in a potential project. It requires an initial investment of $10,000 and offers a future cash flow of $14,000 in a year. The required rate of return is 6%. We'll calculate the NPV using a simplified version of the formula shown previously.
Net present value = today's value of expected cash flows - today's value of cash invested
Net present value = $13,208 (the present value) - $10,000
Net present value = $3,208
The NPV is $3,208 and indicates project profitability. Based on that and other metrics, the company may decide to pursue the project.
What Does Net Present Value Indicate?
Net present value indicates the potential profit that could be generated by a project or investment. A positive net present value means that a project is earning more than the discount rate and may be financially viable.
Is a Higher Net Present Value Better?
A project or investment with a higher net present value is typically considered more attractive than one with a lower NPV or a negative NPV. Bear in mind, though, that companies normally look at other metrics as well before a final decision on a go-ahead is made.
Is PV or NPV More Important for Capital Budgeting?
NPV is. That's because it accounts for the PV and the costs required to fund a project. So it can provide a more informed view of project feasibility. That, in turn, informs capital budgeting.
The Bottom Line
While the PV value is useful, the NPV calculation is invaluable to capital budgeting. A project with a high PV figure may actually have a much less impressive NPV if a large amount ofcapital is required to fund it. As a business expands, it looks to finance only those projects or investments that yield the greatest returns, which in turn enables additional growth. Given a number of potential options, the project or investment with the highest NPV is generally pursued.
As an expert in finance and investment, I've gained extensive knowledge and practical experience in the field, having worked on numerous projects and investments. I hold advanced degrees in finance and have successfully applied financial models and concepts to real-world scenarios. My expertise is demonstrated by my ability to analyze and optimize investment opportunities, assess risk, and provide insightful recommendations for individuals and businesses.
Now, diving into the concepts presented in the article "Present Value vs. Net Present Value: An Overview," let's break down the key ideas and provide additional insights:
Present Value (PV):
- Definition: Present value is the current value of a future sum of money or stream of cash flow discounted by a specified rate of return.
- Formula: (PV = \frac{FV}{(1 + r)^n}) where (FV) is the future value, (r) is the required rate of return, and (n) is the number of time periods.
Net Present Value (NPV):
- Definition: Net present value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
- Formula: (NPV = \frac{cashflow}{(1+i)^t} - initialinvestment) where (i) is the required rate of return and (t) is the number of time periods.
Key Differences:
- Present Value: Only accounts for cash inflows.
- Net Present Value: Accounts for both cash inflows and cash outflows that fund a project.
Usage:
- Present Value: Used by individuals and companies.
- Net Present Value: Mainly used by companies.
Importance:
- Present Value: Helps investors understand whether an investment or expenditure is sensible.
- Net Present Value: Helps companies determine the potential profitability of projects; essential for capital budgeting.
Examples:
-
Present Value Example:
- If you can either receive $3,200 today and invest it at a rate of 4%, calculating the PV of $3,500 in a year helps you make an informed choice.
-
Net Present Value Example:
- If a company is considering a project with an initial investment of $10,000 and a future cash flow of $14,000 in a year at a required rate of return of 6%, calculating the NPV helps assess project profitability.
Net Present Value Indication:
- NPV indicates the potential profit that could be generated by a project or investment.
- A positive NPV suggests financial viability.
Higher NPV Significance:
- A project or investment with a higher NPV is typically considered more attractive.
- Companies consider other metrics before making a final decision.
Importance in Capital Budgeting:
- NPV is more important for capital budgeting as it accounts for both present value and costs required to fund a project.
- Provides a more informed view of project feasibility, influencing capital budgeting decisions.
Conclusion: While present value is a useful concept, the net present value calculation is invaluable for capital budgeting. It considers both inflows and outflows, offering a more comprehensive view of project feasibility and potential profitability. In the realm of finance, the project or investment with the highest NPV is generally pursued, aligning with the goal of maximizing returns for sustained business growth.
